Using Life Insurance for Leverage Inside of a Dynasty Trust

Introduction

The Wall Street Journal recently highlighted dynasty trusts, one of the most effective estate planning tools available to high-net-worth individuals and families. There are long-term trusts designed to pass wealth across multiple generations without incurring estate and gift taxes. Pairing a dynasty trust with life insurance can magnify its benefits, offering even greater financial security and enhancing legacy planning for generations.  

Understanding the Dynasty Trust

Before delving into the interplay of life insurance and the dynasty trust, it's crucial to understand the trust's fundamentals. A dynasty trust is a type of irrevocable trust set up to benefit not just immediate children or grandchildren, but many generations down the line. Thanks to the generation-skipping transfer (GST) tax exemptions, the assets inside a dynasty trust can continue to grow and benefit descendants without being eroded by estate taxes or generation-skipping transfer taxes.

Understanding Life Insurance

Life insurance has codified tax attributes that make this asset unique and attractive on its own.  If properly structured, the tax-free death benefit makes life insurance one of the only assets that gets a “stepped up basis” at death when held in trust (Revenue Ruling 2023-2).  The tax-free growth of policy cash value helps to manage taxation for the trust tax payor and, perhaps, leave more to beneficiaries.  If a policy has sufficient cash value, loans may be taken by the trustee for the benefit of trust beneficiaries during the insured’s lifetime.  However, taking policy loans reduces the death benefit and may imperil the success of the plan if not regularly reviewed with an insurance professional.

Combining the two strategies.

Let’s use a client example to illustrate this powerful concept.  Suppose we have a married couple with a net worth that makes sense for dynastic planning.  Say, $100MM.  This couple has the net worth and liquidity to pay both the transfer taxes owed at their second death, plus the ability to provide a legacy to descendants at their passing.  They have each gifted cash equal to their combined lifetime exemption of $25.84M¹ to a dynasty trust.

Rather than having the trust invest the cash in a traditional investment portfolio of stocks and bonds, the trustee chooses to allocate a portion of the gift to a second to die life insurance policy on the lives of the grantors/clients (G1).  This accomplished the client’s goals for using life insurance, which in short, to create guaranteed leverage in the form of a tax-free cash many times the premiums paid when the death benefit is paid to the trust at their second passing².  

It is common for family wealth to be significantly diminished with each successive generation. As a strategy to protect their legacy for their grandchildren and generations after, the trustee also allocates a portion of the lifetime gift allocated towards life insurance on the client’s two children (G2).  With some creative design, the policies on G2 can accrue cash value during their respective lifetimes, to be accessed during G2’s lifetime if need be.  More likely, the policies will be held until they mature as a claim for the future grandchildren (G3).  Assuming normal life expectancy for G1 and G2, the combined death benefits of the policies create powerful leverage, resulting in significant wealth for future generations.  

The Power of Cash Value Life Insurance Within a Dynasty Trust

1. Tax-free Death Benefit: When a life insurance policy is held inside a dynasty trust, the death benefit is paid directly into the trust free of income and estate taxes. This tax-free infusion of cash can provide a significant boost to the trust's assets, benefiting multiple generations.

2. Asset Preservation: The policy’s death benefit provides asset preservation, particularly if the insured(s) dies during down markets and family upheavals.

3. Liquidity and Diversification: While the trust may hold various assets, the immediate liquidity provided by a life insurance death benefit can be advantageous. It can be used to meet any immediate financial needs, pay any outstanding estate debts or taxes, or rebalance the trust's portfolio.  

4. Tax Free Access to Cash Value: Depending on the policy style and funding, it can provide liquidity to trust beneficiaries during the insured’s lifetime if the trustee takes loans against the policy for their benefit.  Some policies are funded precisely for taking such income, however, this should be done with care and the advice of an insurance professional.  Not all policies are suitable for this purpose.  Taking loans against the policy reduces the policy’s death benefit, causes loan interest to be charged, and may impair long-term policy performance.  

Strategic Considerations

• Trust Funding: Dynasty Trusts are generally funded with gifts or loans; resulting in the transfer of cash or other assets.  Life insurance premiums must be paid in cash.  Therefore, it’s critical that the trust have enough cash or cash producing assets to fund ongoing premium payments.  Which assets to gift to trust should be carefully considered to avoid liquidity or tax concerns.

• Policy Type and Funding: There is a wide range of products available, offering varying levels of guarantees and growth potential.  It may make sense to consider funding the policy creatively to maximize the internal rate of return of the death benefit at life expectancy.  Risk tolerance, anticipated longevity, and trust cash flow should be considered in this selection.
• Trustee Selection: The trustee has the responsibility of managing both the trust administration, trust assets, and the insurance policy. Ensuring that the trustee understands the intricacies of managing life insurance within the trust and has the support needed to do so is critical.

Conclusion

Merging the advantages of a dynasty trust with the benefits of life insurance creates a powerful tool for wealth preservation and intergenerational wealth transfer. It provides a means to protect assets, benefit from tax-free growth, and ensure that future generations enjoy financial security.

However, integrating life insurance into a dynasty trust requires careful planning and regular review. It's always recommended to work with knowledgeable team of professional advisors, including a life insurance expert, to maximize the benefits and navigate the complex financial landscape.

‍